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What explains credit booms?
Credit booms can be triggered by a wide range of factors, including shocks and structural
changes in markets.
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Shocks that can lead to credit booms include changes in productivity,
economic policies, and capital flows. Some credit booms tend to be associated with positive
productivity shocks. These generally start during or after periods of buoyant economic
growth. Dell’Ariccia and others (2013) find that lagged GDP growth is positively associated
with the probability of a credit boom: in the three-year period preceding a boom, the average
real GDP growth rate reaches 5.1 percent, compared to 3.4 percent during a tranquil three-
year period.
Sharp increases in international financial flows can amplify credit booms. Most national
financial markets are affected by global conditions, even more so today, making asset
bubbles easily spill across borders. Fluctuations in capital flows can amplify movements in
local financial markets when inflows lead to a significant increase in the funds available to
banks, relaxing credit constraints for corporations and households (Claessens et al. 2010).
Rapid expansion of credit and sharp growth in house and other asset prices were indeed
associated with large capital inflows in many countries before the recent financial crisis.
Accommodative monetary policies, especially when in place for extended periods, have been
linked to credit booms and excessive risk taking. The channel is as follows. Interest rates
affect asset prices and borrower’s net worth, in turn affecting lending conditions. Analytical
models, including on the relationship between agency problems and interest rates (e.g.,
Stiglitz and Weiss, 1981), suggest more risk-taking when interest rates decline and a flight to
quality when interest rates rise, with consequent effects on the availability of external
financing. Empirical evidence (e.g., for Spain, Maddaloni and Peydró, 2010; Ongena et al.
2009), supports such a channel as credit standards tend to loosen when policy rates decline.
The relatively low interest rates in the U.S. during 2001-04 are often mentioned as a main
factor behind the rapid increases in house prices and household leverage (Lansing, 2008;
Hirata et. al, 2012).
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For reviews of factors associated with the onset of credit booms, see further Mendoza and Terrones
(2008 and 2012), Magud, Reinhart, and Vesperoni (2012), and Dell’Ariccia and others (2013).
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However, whether and how monetary policy affects risk taking, and thereby asset prices and
leverage, remains a subject of further research (see De Nicolo and others (2010) for recent analysis
and review). The extent of bank capitalization appears to be an important factor as it affects
incentives: when facing a lower interest rate, a well-capitalized bank decreases its monitoring and
takes more risk, while a highly levered, low capitalized bank does the opposite (see further
Dell’Ariccia, Laeven and Marquez (2010)).
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Structural factors include financial liberalization and innovation. Financial liberalization,
especially when poorly designed or sequenced, and financial innovation can trigger credit
booms and lead to excessive increases in leverage of borrowers and lenders by facilitating
more risk taking. Indeed, financial liberalization has been found to often precede crises in
empirical studies (Kaminsky and Reinhart, 1999; Detragiache and Demirguc-Kunt, 2006).
Dell’Ariccia and others (2013) report that roughly a third of booms they identify follow or
coincide with financial liberalization episodes.
The mechanisms involved include institutional weaknesses as well as the perverse effects of
competition. One channel seems to be that regulation, supervision, and market discipline is
slow to catch up with greater competition and innovation (possibly set in motion by shocks
or liberalization). Vulnerabilities in credit markets can naturally arise. Another mechanism
commonly linking booms to crises is a decline in lending standards. Greater competition in
financial services, while generally enhancing efficiency and stability in the long run, can
contribute to financial fragility over shorter periods. For the latest crisis in the United States,
this was evident in higher delinquency rates in those metropolitan areas with higher growth
in loan origination prior to the onset of the crisis, with the deterioration in lending standards
appearing in part related to increases in competition (Dell’Ariccia, Igan and Laeven, 2012).
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